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Power of Price and Problem of Subsidy

Price is perhaps the most powerful mechanism in any market based economy. I am not going to spend much time talking about the detailed role of price, but in general we need to understand why it is so important. Price acts as THE signal in the market of relative scarcity given supply and demand. What this means is that a stand-alone price will find the appropriate level to hover around in the market, while having fluctuations in response to changes in the variables. Prices can change for many reasons, but just having this basic understanding of the role of price, we can talk about why fuel subsidies can be a problem.

I am going to focus this post on oil subsidies and why we should really think hard about changing what we do. In 2011 the IMF put out a study that 480 Billion dollars were spent on petroleum based subsidies. Now, without getting into the fact that we spend that much money on oil subsidy, that can play a big role in the way that price is supposed to relate the current environment in the market. Remember, price should tell us what is going on.

So for example, if we are running out of oil then we should see that price is going up (decrease in supply), provided that demand in not decreasing at an offsetting amount, and its not. Demand is actually increasing significantly. So we should expect gas prices to increase. Okay, now you might be saying that well they are increasing so what are you talking about. The subsidies we as tax payers are paying for, artificially lower the price we see. Which means that the true signal is not being sent to the market. Why is this so crucial? If the true price was represented in the market then we could respond appropriately to finding alternatives. So as we began to experience a situation in which the price tells us that for one reason or another, gasoline is becoming a problem. This would then provide the incentive for the most powerful tool we have, innovation, to step into the market and look for the solutions.

Maybe you say well we are trying. Okay, yeah we have tried but not to the full capacity that would ensue if the true price was provided. Additionally, we would have vastly different requirements for what is an acceptable alternative, and those alternatives would have more competitiveness in the market without having to provide them with billions of subsidies. This means if we removed subsidies to artificially keep the price down we would not only improve the signals in the market but also reduce the need to subsidize clean and alternative fuels. I think that is a win-win. Comment if you agree or disagree and find me on Twitter @devinxcombs